Fixed income managers have recently had to practice a rarely used skill; explaining poor investment performance to their clients. Bonds have been a great investment for a long time, but Fed Chairman Bernanke’s press conference last month has at least introduced two-way risk into the market. Quite possibly, he heralded the end of the secular bull market in bonds, a run that has lasted with few interruptions for over thirty years. Certainly the past few weeks have not been much fun for bond investors. If a generational low in U.S. interest rates really has taken place and bond yields are about to move irregularly higher, it will be a drawn out process. Bond managers will need to find variations on the theme that holding an asset that loses you money is a good idea because it’s uncorrelated with your other assets. After a few quarters it may become a rather tedious discussion.

By fortunate coincidence, my new book Bonds are Not Forever; The Crisis Facing Fixed Income Investors looks as if it will be coming out at a time when falling bond prices are on the minds of many investors. Few books currently advise on the dangers in bond investing. No doubt there will be more. The finished manuscript went in to publisher John Wiley this week. Reaching the goal line partially explains my relatively few recent blog postings.

The Eurodollar futures curve offers quite precise market forecasts of interest rates. You can compare them with the FOMC’s own forecasts on their website. The consensus among FOMC members is that they’ll begin raising short term rates in 2015. Eurodollar futures currently price in 53 bps between September 2015 and March 2016, or about two 25 bps tightenings over two quarters. Such a measured pace is probably a neutral forecast right now, which is to say that the futures market and the FOMC are in reasonable agreement on the near term path for short term rates. That’s about as close as you can get to saying bonds are fairly valued. They’re certainly not a good investment at current yields, but the market has largely removed the expectation of a more benign monetary regime than that forecast by the FOMC itself.

It’s a long time since we had a bear market in bonds. Some may remember 1994, when Greenspan shocked the market from its complacency with a series of hikes in the Fed Funds rate. Events culminated that year with the bankruptcy of Orange County due to ill-advised bets on continued low rates by its treasurer Robert Citron. Or 1987, when a weak US$ and rising trade deficit led to rising bond yields and ultimately a stock market crash. The economy barely reacted to the turmoil on Wall Street and continued its expansion.

The problem today for bond investors is that, although the value in bonds is somewhat better with higher yields, they’re still not remotely cheap. The FOMC tells you on their website that the equilibrium Fed Funds rate is 4%. They don’t tell you when we’ll get to that level, but a clear consensus of FOMC members expects to begin raising the Fed Funds rate by 2015, two years from now. Even a measured pace of 0.25% per quarter would get short term rates to 4% by 2018. On that basis, a ten year treasury note yielding 2.4%, albeit 0.80% or so better for investors than a few months ago, doesn’t exactly represent compelling value. Personally, I think ten year notes would need to yield 4%, or 2% over inflation, before they’d even be worth considering. The same applies to corporate bonds adjusted up by an appropriate credit spread. The realization that the Fed will, in the foreseeable future, curtail their support of bond prices reveals how little true value they offer once the biggest buyer modifies its interest.

Based on what the FOMC discloses publicly about their rate forecasts – and their forecasts are more important than yours or mine since they can make them happen – I imagine Ben Bernanke must not think bonds represent a particularly good investment for anyone who’s a commercially driven investor. In other words, unless you’re a central bank looking to influence rates or park large reserves somewhere safe, don’t do what I’m doing.

In spite of the equity market’s poor reaction, it’s worth considering that the FOMC’s latest move (or signaled move, since they haven’t actually curtailed their $85 billion a month in purchases) may be well judged. So far since 2008 you’d have to give them credit for pursuing unconventional means boldly. Inflation remains low and economic growth remains positive although unemployment is still high. The Bernanke haters who own gold and gold-related investments on the dubious grounds that some greater fool exists to pay a higher price for a fairly useless, heavy, non-income generating mineral have done even worse than bond investors. As the Irish builder in Fawlty Towers sagely noted to Basil following a botched job, “There’s always someone worse off than yourself, Mr. Fawlty.” To which Fawlty replied, “Well I’d like to meet him then. I could do with a laugh.” So Mr. Bond Buyer, cast your gaze on the Gold Bugs and cheer up.

In “Running Low on Bonds”, the WSJ today notes that bond funds are increasingly holding stocks because of the shortage of attractive bonds to buy. They cite the Loomis Sayles Strategic Income fund as an example. Common and preferred equity is now 19% of its portfolio, versus 5% in mid-2011.

We’re sympathetic to the argument. Bonds are a horrible investment. But if investors choose a bond fund and the manager buys equities, whatever asset allocation decision made by the client is being distorted. What the Loomis Sayles managers are saying is that their clients should hold less in bonds, and they’re going to help you with that asset allocation shift by doing it themselves. It’s not that stocks are necessarily a poor choice – far from it. But in the next bear market Loomis Sales clients may find they have more equity exposure than they expected to have based on their asset allocation.

Bill Gross is by any measure financially sophisticated. Which is why it’s entertaining to watch him reconcile his undoubtedly well-honed skills at investing with his firm’s management of one of the most overpriced closed end funds around. The closed end fund sector is one of the truly inefficient sectors in financial markets. Investors routinely confuse distributions with yield, and presume that a security sporting a 10% yield is offering good value that has just been overlooked by many other investors.

So it is that the Pimco High Income Fund (PHK) recently reached a price of $14, a heady 70% premium to the NAV of its assets. It reached this level because investors are searching for yield everywhere, and because Bill Gross is the portfolio manager. For many investors, Bill Gross at any price is better than the tyranny of low market rates, and who can blame them.

Barron’s ran an article on the weekend noting the absurdly high premium to NAV of this fund. Mr. Gross does eats his own cooking by investing a modest amount of his net worth in the fund. He would know as well as anybody that investing in a portfolio of high yield bonds at 70% above their market value is not a sensible strategy, and yet as PM he can hardly advise that way nor sell his own shares. This week PHK has fallen spectacularly (at least, by the standards of closed end funds) falling around 20% from its level of last week. It still sports a heady 50% premium, and perhaps that will be sustained. It’s not possible to short it, but let’s just say there are quite a few more sensible places to put your money than PHK. Unless you’re the PM there’s not much point in owning it.

The Fixed Income market has been a tough place to find much value for far longer than I can remember. And yet, that hasn’t stopped the returns from being nothing short of spectacular. In fact, it’s not hard to find securities that have outperformed equities, and most would agree that it’s been a surprisingly good year for stocks.

Take the iShares Investment Grade Bond ETF (LQD) for instance. Up 10.5% year-to-date, for high grade bonds debt. The current yield to maturity on the portfolio is 2.89%, and a good part of the return for the year has come from price appreciation of the underlying bonds as the Fed’s relentless buying of government and mortgage debt has drawn investors to bid up the prices of other fixed income securities. If LQD returns 10.5 over the next year, 7.6% of that return will have to come from price gains which, given its effective duration of 7.8 means the yield to maturity will need to fall to under 2%.

The JPMorgan Emerging Market Bond Fund (EMB) has generated 14.5% so far this year, only 2% or so less than the S&P500. The yield on this portfolio has drifted down to 4.1%. For EMB to return 14.5% over the next 12 months, the same Math as in LQD means that, with an effective duration of 7.7 the yield to maturity will need to fall to 2.75%.

Even more striking has been the performance in some of the closed end funds that invest in senior loans. We’ve liked the ING Prime Rate Trust (PPR) for quite some time, but evidently we’re not alone for it currently trades at a 4% premium to NAV. PPR has returned a staggering 28% so far this year as investors have piled into bank debt and high yield in general.

There’s never any easy money to be made, but none of these investments appears that compelling today. Earning the current yield would seem to be the best plausible outcome on LQD and EMB. This morning’s Employment report was also reasonably positive, with the Unemployment rate falling below 8% for the first time in over three years. We’ve owned these securities in our Fixed Income Strategy but recently exited. The risk/return just doesn’t appear attractive, though bonds have looked expensive for a long time with barely a pause in the march to ever lower yields.

March 2022. That is the point at which, according to eurodollar futures prices, three month Libor will reach the heady yield of 4%. Ten years from now until money market yields are restored to “equilibrium” as defined by the FOMC in their rate forecast issued for their January 24-25 meeting earlier this year (reproduced below). The time to reach equilibrium is not defined in their forecast, so plausibly their forecast could be consistent with market interest rates. But I suspect that if asked whether it’ll take ten years for conditions to return to normal, Ben Bernanke would sound somewhat more optimistic than that. Or put another way, if during one of his testimonies before Congress he suggested that we have another ten years of digging to get out of the economic hole we dug in ’07-’08, many Congressmen might take the view that this is far too long.

So the bond market disagrees with this outlook. Bond investors believe we are ten years away from full recovery, while the government believes or hopes that this is far too pessimistic. Forecasts can differ, but meanwhile I keep returning to the fascinating optics of the Federal Reserve imposing on the market (through Operation Twist and its predecessors) long term interest rates that reflect market forecasts they themselves find too pessimistic. The only way to reconcile the Fed’s actions with its forecast is to acknowledge that its bond purchases are uneconomic – indeed, they are intended to be so. As the logic goes, maintaining stimulative interest rate policies is the best way to assure that ultimate recovery and an improved labor market both transpire.

It’s rare that a central bank provides so much information about its thinking. An easy way to square the circle would be for the FOMC to produce rate forecasts that are consistent with the yields at which they’re buying bonds. It would ensure consistency between their actions and their forecasts, but to their credit the Fed is promoting far greater transparency than they did under Greenspan. Consequently, presuming that the FOMC doesn’t seriously believe it’ll be ten years before a return to equilibrium interest rates, they are investing at yields too low for any commercially driven bond buyer. This is not even a guess; the Fed is telling you so! The Fed doesn’t need to make profitable investments, and they likely expect to hold what they own until maturity. But if you could catch Bernanke at an unguarded moment, perhaps over a glass of wine with no press nearby, he would surely acknowledge this incongruity and justify it based on the Fed’s twin mandate of promoting full employment consistent with stable inflation. The Fed is doing what they’re supposed to. And they are explaining it as plainly as anyone could hope.  Today’s bond buyer needs to be a very definitely not-hold-to-maturity type to make a profitable investment in ten year treasuries at 2.3% (or corporate bonds tethered through credit spreads to this return-free yield). If it turns out badly because the Fed starts raising rates with a view to reaching their longer run objective before 2022, it’s because the investor didn’t become a trader quickly enough.

Jeffrey Lacker, President of the Richmond Fed, thinks rates may need to rise as soon as next year. He is presumably one of the dots in the chart reproduced below, and no doubt one of the more hawkish. How fascinating to be able to ask him what he thinks of current interest rates. In fact, he’s already told you.

Although treasury yields have risen around 30 bps over the past couple of weeks, yields have not yet reached what the Federal Reserve itself might call equilibrium. The FOMC rate forecasts that the Fed published earlier this year reveal an intriguing inconsistency between the Fed’s actions and its own market forecasts. Operation Twist and its predecessors are intended to drive down long term borrowing costs, to the benefit of those who can access those markets (qualified homebuyers through mortgages, investment grade corporations and of course the Federal government itself).  This along with concerns about Europe have pushed yields lower.

The Fed published rate forecasts from each FOMC member earlier in the year. Their interest rate forecasts are at odds with the term structure of interest rates, which the Fed of course is heavily influencing. The FOMC expects the long run, equilibrium Fed Funds rate to be around 4%. Although they don’t say when the rate will reach that equilibrium level, it seems reasonable to suppose that their forecast horizon wouldn’t be longer than five years. And yet, the 5 year forward treasury rate in five years (derived from the five and ten year treasury yields) is around 3.5% (it was close to 3% before yields began rising recently). The market forecast for short term rates in five years is 0.5% lower than the FOMC’s forecast.

It’s not a huge difference, but what’s interesting is that the Fed’s Operation Twist, by forcing long term yields down, is at odds with their own rate forecasts. By their own admission they don’t believe long term bonds at current yields are a good investment. Their own actions, based on their own forecasts, are not designed to be profitable for them or for anyone following them.

Corporate bond issuance has been running at record levels so far this year, spurred by corporations wishing to lock in low rates. Retail investors have happily taken the other side. The question is, since the Fed is clearly a non-economic buyer and is forcing yields down to levels that their own rate forecasts show to be unprofitable, should this be made more explicit to the retail investors that are buying at current levels? If the government is consciously seeking to make some investment uneconomic, shouldn’t they just say that in plain English? This isn’t critical of Operation Twist or earlier efforts by the Fed to maintain low long term rates – such moves have so far probably been good.

But when retail investors hiding in fixed income start to see losses on their holdings, they might wish the Fed had told them more clearly the risks they were facing. Long term bonds are still a poor investment.

Eurodollar futures provide quite precise data about the market consensus forecast for interest rates. Since they extend out for ten years, they provide a rich set of information constantly updated about where market participants think 3 month Libor will be every three months.

The FOMC recently started making public the interest rate forecasts of its members. They issued a graphical representation of when FOMC members expect to begin tightening and what each member expects the year-end rate to be through 2014. You can find it here listed as “Projection Materials” for their press conference. For some weeks now I’ve felt that there exists a mild discrepancy between the rate forecasts imbedded in the eurodollar futures curve and the FOMC’s forecasts. For instance, only 6 of 17 FOMC members expect the Fed to begin tightening by 2013, whereas 11 (i.e. a majority) expect so by 2014. So the majority think they’ll be raising rates no later than 2014. Similarly, the median rate forecast of FOMC members at the end of 2013 is 0.25%, but a year later it’s 0.75%. Moreover, if you compare the average forecast rather than the median, rates are expected to move from 0.56% to 1.12% (there are a couple of outliers on the high side). So on balance, it looks as if the FOMC expects short term rates to rise around 0.5% during 2014.

Meanwhile, the spread between the September 2013 and September 2014 eurodollar futures yields is 0.36%. The market is priced for less of a tightening than the FOMC is forecasting.

Now eurodollar futures and the yield curve in general are analyzed probably more closely by more smart people than any other variable in financial markets. In addition, not all FOMC members vote, and it’s not clear what each members’ forecast is (although you can make some reasonable assumptions based on public comments by individual members). Current market pricing is not an oversight, it correctly reflects market expectations. And yet, were you able to sit in on a discussion of the FOMC, or better yet debate interest rate forecasts with them, they would likely tell you that the yield curve out to three years is not pricing in enough of a tightening of short term rates. Of course, the FOMC’s forecast could be wrong; after all, they really don’t know more than anyone else about what the economy will be doing in 2014. One interpretation of market pricing is precisely this – FOMC members are overly optimistic about GDP growth and the economy will still be facing headwinds 2-3 years out.

This may be so, and yet the knowledge that the FOMC thinks the yield curve is too flat would have been considered valuable inside information not so very long ago. Today, it’s public information. And they are of course in a position to make their forecasts come true.

The view that the yield curve is too flat can be most easily expressed through a long eurodollar futures calendar spread (long September 2013 and short September 2014), betting on a wider spread or steeper yield curve between those two points. Not everyone chooses to trade futures, but the rate forecasts revealed explicitly in the eurodollar futures curve are part of the term structure of bonds as well. Although the eurodollar futures market makes plain the precise path of interest rates the market expects, bond yields of different maturities are priced to be largely consistent with the same information. So an investor today who selects five year bonds over shorter maturity two years in exchange for the modest yield pick-up available is effectively rejecting the FOMC’s interest rate forecast as too optimistic on the economy. The FOMC is telling you they think you’re making a mistake.

Disclosure: Author is Long the September 2013/2014 eurodollar calendar spread.

We continue to like using a short Euro position in combination with risky assets. In our Fixed Income Strategy we’re invested in senior loans through closed end funds such as BlackRock Defined Opportunity Credit Trust (BHL) and ING Prime Rate (PPR). They’re both at a modest discount to NAV of around 5%, and yield over 6%. Their portfolios of leveraged loans to non-investment grade borrowers will no doubt go down if equities sell off, but holding this position in combination with a short Euro (we’re long EUO) protects against the tail risk associated with Euro sovereign debt problems or Middle East conflict (such as an Israeli attack on Iran). The US has a 3% GDP differential over the Eurozone so over time this should favor the US$ anyway. Short Euro is akin to owning put options on the market – you just need to own something in addition that will generate a return.

There were a couple of interesting articles about energy over the past 24 hours. The WSJ noted that natural gas is eating into demand for coal. Over the past three years natural gas has gone from producing 21.4% of U.S. electricity to 24.4% (coal has dropped from 48.2% to 42.8%). It’s a slow process and don’t expect near month natural gas to trade at $4 anytime soon. But it does illustrate market forces at work. In another article, Bloomberg notes that the U.S. is on its way to achieving energy independence . By way of illustration, they report that Methanex, the world’s biggest producer of methanol, is dismantling a factory in Chile and moving it to Louisiana to take advantage of cheap natural gas. We continue to own Comstock Resources (CRK), which reported earnings yesterday and expects production to be 20% oil by the end of 2012. They have minimal debt, low operating costs and while today’s low natural gas prices don’t help the company does control its own destiny and trades at a healthy discount to book value (even after taking a reserve writedown in 4Q11).

Finally, Bill Gross wrote an interesting piece on the problem with low interest rates in yesterday’s FT. He suggests that QE2 and Operation Twist are keeping long term rates so low that banks don’t see much upside in lending there. This slows down the recapitalization of the banking system that a steeper yield curve would provide. Whether he’s right that this is slowing growth or not, he’s certainly right that long term rates provide little incentive to lend. Long term high grade and government bonds are a safe way to lose purchasing power. An obscure but interesting trade can be found in the eurodollar futures curve. The spread between Sept 2013 and Sept 2014 is 35 or so basis points. The market is pricing for an increase in three month Libor of only 35 bps between 2013 (when a majority of FOMC members expect short term rates to be unchanged) and 2014 (when a majority expects them to be rising). This spread is unlikely to narrow much beyond 25-30 under those circumstances, and an upside surprise in GDP growth (perhaps led by housing?) could cause a substantial steepening in this part of the curve, straddling as it does the point at which the Fed has indicated it will start raising rates. We think it’s an interesting trade, there’s probably no need to rush into it though.

Disclosure: Author is Long PPR, BHL, CRK, EUO

Morningstar reported through the Wall Street Journal that PIMCO’s $244BN Total Return Fund (PTRRX) suffered the first outflow on its history last year. $5BN left the fund in 2011 including $1.4BN in December as investors soured on PIMCO’s mis-timed trades in U.S. government bonds. Bill Gross hasn’t achieved what he has by accident, and no doubt many more good years lie ahead. But the Federal Reserve’s distortion of interest rates, through Quantitative Easing (QE) Versions 1 and 2 and more recently Operation Twist illustrate the problem. Bond yields today do not reflect the private market’s appetite to lend money; they are being held down by the Fed’s buying. Consequently, ten year treasuries offering a yield of less than 2% are guaranteed to slowly erode the real value of the money invested in them even in a tax-deferred or tax-exempt account. For a taxable investor the erosion takes place more quickly.

Last Summer PIMCO publicly spurned U.S. debt as offering an insufficient return, and after lagging the indices badly while a Fed-induced rally took hold they reversed course. PIMCO no longer hates government bonds and a look a the holdings of PTRRX on Morningstar reveals several positions in long term government bonds. 2.3% is invested in the 3.5/8 of 2/2021; 1.5% in the 2.1/8% of 8/2021, and so on. 27% is in government debt – and yet, since the hold to maturity real return will most assuredly be negative, the justification for these holdings is that they will zig when other things zag. In a flight to quality, “risk off” trade (in which the market engages fairly often) holdings of treasuries can be relied on to retain their value or even appreciate. The negative return is in exchange for reduced volatility, and extracting real value from such holdings therefore requires that they be sold by a nimble PM at precisely the time of crisis. This is increasingly what active bond managers are faced with – they need to be good at market timing to justify some of their holdings.

PIMCO may well be good at that too, last year notwithstanding. As the government stealthily imposes loss of purchasing power on savers, successful bond managers will be those who are nimble enough to keep time to the music.